Keynes’ psychology and behavioural macroeconomics: Theory and policy

Abstract

Until recently, modern macroeconomic models have remained solidly grounded on assumptions of rational expectations, efficient markets and representative agents, with policy prescriptions focused on the power of markets, and complex and esoteric financial intermediation instruments justified as solutions to problems of asymmetric information and risk. In modern microeconomics, behavioural economic analysis has flourished, focusing on individual responses and interactions. By contrast, in macroeconomics, humans are assumed to behave as if they are mathematical machines, making decisions in a mechanical, objective way. From this perspective, it is difficult to properly capture the instabilities that characterise modern macroeconomies and financial systems. While some progress has been made in recognising the bounds to rationality, the complexity of the macroeconomy can be captured fully only by embedding psychological and sociological forces more fully into macroeconomic models. Keynes was a pioneer in analysing the impacts of socio-psychological influences on macroeconomic phenomena. This article explores some of Keynes’ fundamental ideas about socio-psychological macroeconomic influences, including insights from A Treatise on Probability (1921) onwards, and links these insights both with modern behavioural economic theory and current macroeconomic policy debates.

Capital investment, business behaviour, and the macroeconomy

“…These models pre-date recent developments in behavioural economics, in particular insights from behavioural economics exploring the anomalies that emerge in decisionmaking when time and risk preferences are unstable and/or when heuristics (simplified decision-making tools) are used. While behavioural macroeconomics has explored the impacts of behavioural influences on consumption, labour markets, and asset markets (e.g., see Akerlof, 2002;Driscoll & Holden, 2014), behavioural influences on aggregate investment have not explored in depth, except indirectly via the analysis of aggregate supply/demand, consumption, impacts of learning on expectations, and impacts of animal spirits on business confidence (e.g., see Akerlof & Shiller, 2009;Baddeley, 2014Baddeley, , 2016Baddeley, , 2017de Grauwe, 2011de Grauwe, , 2012Evans & Honkapohja, 2001;Farmer & Guo, 1994;Gabaix, 2020;Howitt & McAfee, 1992;Katona, 1946).…”

Behavioral Factors Affecting Household Over-Indebtedness: A Systematic Review

“…Some macroeconomic issues have been addressed by behavioral macroeconomists using behavioral assumptions (Gabaix, 2016). The General Theory of Employment, Interest, and Money-1936 (GT) is an example of Keynes' consideration of uncertainty and psychology in the macroeconomy (Baddeley, 2017). Furthermore, the classical theory's assumptions about the specific situation are not true of the economic system in which we actually live; thus, trying to apply its lessons to reality will only make matters worse (Hicks, 1936).…”